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Opinion: Why Guernsey needs to reform its company tax system

Opinion: Why Guernsey needs to reform its company tax system

Monday 04 April 2022

Opinion: Why Guernsey needs to reform its company tax system

Monday 04 April 2022


The States are grappling with projections of deficits in public finances of several tens of millions of pounds a year in the foreseeable future. Their senior committee, Policy & Resources, favours the introduction of Goods and Services Tax (GST), but most other States' members have already indication their opposition.

Deputy Charles Parkinson is a Chartered Accountant and Barrister who was the island's Treasury Lead between 2008 and 2012. He believes that the zero-ten company tax regime needs to be reformed before there is any further consideration of raising personal tax. Here, he tells Express readers why:

REFORM OF GUERNSEY’S CORPORATE TAX SYSTEM

Background

Historically, there have been two alternative bases for taxation of corporate income – the worldwide income basis and the territorial basis. 

Under the worldwide income basis, a company is subject to tax in the country or state where it is resident on all of its income from anywhere in the world. Since this could give rise to double taxation in respect of income arising in foreign countries, the country of residence normally gives the taxpayer credit for foreign taxes paid on its foreign-source income.

Non-resident companies are taxed in the state in question only on their income from that state.

Under a territorial tax system, a company - wherever it is resident - pays tax in any particular country or state only on the income it receives from within that country or state. Territorial tax systems often operate under other names, but it is the effect of the systems which is important.

In the 1980s, 24 countries operated a fully worldwide income basis, but since then there has been a consistent trend towards the territorial tax system.

The Netherlands had already emerged as a ‘tax haven’ in the 1970s, due to the ‘participation exemption’ in Dutch tax law, which allowed a Dutch parent company to exclude from its taxable income any dividends from an ‘active’ subsidiary in which the parent company owned at least a 5% interest, as well as the profits of any foreign ‘permanent establishment', e.g. a branch office. This effectively created a territorial tax basis and made the Netherlands a hub for international investment.

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Pictured: Deputy Charles Parkinson says The Netherlands was an early adopter of a form of territorial taxation.

In 1990, the EU effectively introduced territorial taxation for groups wholly within the EU with its Parent-Subsidiary Directive. This exempted dividends and other profit distributions paid by subsidiary companies within the EU to their EU parent companies.

In 2009, the UK introduced an election by which a UK company could extend this exemption to income from any foreign subsidiary (or branch), wherever it is incorporated. That election remains available today.

Japan also switched to a territorial tax system in 2009 and the USA introduced a participation exemption system for the taxation of foreign income under the Tax Cuts and Jobs Act of 2019. 

Most countries now use a basis which is at least partially territorial, typically taxing business income on a territorial basis. Some still use the worldwide income basis for some kinds of ‘passive’ income, such as interest and royalties.

The result is that today only four OECD countries use the worldwide income basis exclusively for the taxation of income from foreign subsidiaries: Chile, Israel, Korea and Mexico.

But this is the system that Guernsey uses.

Importantly, several very successful offshore finance centres, such as Hong Kong, Singapore, Luxembourg and Gibraltar, use the territorial income basis.

The shift away from the worldwide income basis towards the territorial basis is continuing. For example, in 2019, Curaçao, a Dutch Caribbean island, adopted a fully territorial tax system. And Ireland, which currently has a partially territorial tax system (after the EU model), is currently investigating a full switch to this basis. Both of these counties are competitors of Guernsey.

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Pictured: Deputy Charles Parkinson says that Ireland has a partially territorial tax system and is considering switching fully to territorial tax.

Anti-Abuse Measures

The adoption of territorial tax systems tends to encourage multi-national groups to shift their profits to subsidiaries located in low-tax jurisdictions, so the trend noted above has been accompanied by extensive anti-avoidance legislation. The most important examples are as follows.

Many countries have introduced ‘controlled foreign company’ tax regimes, to impute to parent companies located within their jurisdiction the profits of subsidiary companies located in low-tax jurisdictions. In the UK, for example, if profits are diverted to a company resident in a low tax jurisdiction, those profits can be imputed to a UK parent company which controls at least 25% of the offshore company (in proportion to their ownership). 

Generally, these rules apply only to companies, but they also apply to a foreign permanent establishment of a UK company if an election to exclude that income from UK taxation has been made.

Similar rules apply in other countries, e.g. in the USA where foreign ‘Sub-Part F’ income can be attributed to US shareholders owning more than 10% of a foreign entity in a low tax area.

Most countries have adopted extensive ‘transfer pricing’ rules, which seek to prevent groups from shifting profits to low tax jurisdictions by artificially manipulating the prices of intra-group transactions. In the UK, these rules are reinforced, for larger companies, by a Diverted Profits Tax, which imposes penal rates on profits diverted outside the UK by transactions which lack economic substance, etc.

Many countries have extensive networks of double tax agreements, which generally contain clauses providing for exchange of information and mutual assistance in enforcing their domestic tax laws. These can help to combat international tax schemes.

Under the OECD ‘Base Erosion and Profit Shifting’ initiative of 2013, no or nominal tax jurisdictions are required to show that companies in their jurisdiction have ‘substantial activities’ if the jurisdiction is not to be classed as one with ‘harmful tax practices’ (potentially leading to sanctions).

In 2021, the OECD announced that 136 countries had signed up to a ‘two-pillar solution’ to the problems arising from the digitalisation of the global economy. The first pillar aims to ensure a fairer distribution of profits and taxing rights among countries with respect to the largest multi-national enterprises. The second pillar will introduce, with effect from 2023, a global minimum corporate tax rate of 15%. This will apply to companies with annual revenues in excess of 750 million Euros.

Ahead of the development of the first pillar of the OECD initiative (referred to above), some countries, e.g. France, have imposed a digital services tax on the supply of digital services.

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Pictured: A global minimum corporate tax rate is expected to be introduced next year and could substantially change the picture of international tax competition.

The EU and Territorial Tax Regimes

In October 2019, the EU’s Code of Conduct Group published its ‘Guidance on foreign source income exemption regimes’. This guidance acknowledges that regimes which charge corporate tax on a territorial basis are not themselves problematic, but these regimes can become harmful if they not only prevent double taxation but also create the possibility of double non-taxation. Specifically, the EU are concerned about regimes that:

  • exclude foreign source passive income from taxation, e.g. dividends, interest and royalties, without any conditions or safeguards, as this could result in non-residents setting up shell companies to receive such income; or
  • exclude foreign source active income from taxation, e.g. trading profits, on a basis which does not align with international tax principles, e.g. by adopting a definition of Permanent Establishment which is not in line with the OECD Model Tax Convention.

The Code of Conduct group said that if jurisdictions exempt passive income they should:

  • implement adequate substance requirements for the entities concerned;
  • have robust anti-abuse rules in place; and
  • remove any administrative discretion in excluding income from taxation.

In 2021, the Code of Conduct Group investigated the Hong Kong tax regime and found it deficient in these respects. In particular, the lack of economic substance    requirements could result in non-residents setting up Hong Kong companies to receive passive income. Hong Kong immediately committed to introducing the required safeguards into its tax system.

The Shift to Territorial Taxation and the ‘Offshore’ world

When the USA was debating moving towards a more territorial tax system, in the early 2010s, several prominent fiscal economists issued warnings that, under a     territorial system, there would be a flood of investment out of the USA and into low tax jurisdictions. The counter argument was that this would be prevented by anti-avoidance measures, such as those set out above.

But in the event, there has been a substantial outflow of investment from the USA and into low tax jurisdictions. For example, Google, Intel, Apple and Pfizer have established their European headquarters in Ireland, which offers a 12.5% corporate income tax rate, on a territorial basis.

The beneficiaries of this stream of capital have been countries which offer access to major markets and low corporate taxes on a territorial basis.

Of course, other factors have played important parts in the decision-making process, such as the availability of a relatively low-cost, highly-educated, English-speaking workforce, but the factors above have been the key ingredients of success.

Thus, the European beneficiaries of the trend have been Gibraltar, Ireland, Luxembourg and Switzerland, while the Asian beneficiaries have been Hong Kong, Malaysia and Singapore.  All of these levy corporate income tax on a territorial basis.

The British Crown Dependencies and Overseas Territories, which have all adopted zero-rate tax products, have missed out on this trend. 

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Pictured: Deputy Charles Parkinson recently told Express that the Policy & Resources Committee should resign if it cannot persuade a majority of States' members to back its preferred option of GST to deal with projected deficits in public finances. 

For example, employment in Guernsey’s crucial finance sector in 2009, just after the introduction of zero-10, was 7,113. In 2021, it was 5,970. At the end of 2008, Guernsey had 48 registered banks. Today that number is 28. The zero-10 regime was promoted on the basis that it would encourage growth in our finance sector. It has failed.

It may be argued that access to markets is not something over which we have much control. The Crown Dependencies were never members of the EU and declined to join when the UK did in 1973. However, even as 'Third Countries', our access to the EU financial markets has been restricted for political reasons. The EU Commission has refused to grant Guernsey a 'Third Country' passport for fund distribution, despite the fact that we meet all of the criteria.

The Situation in Guernsey

Guernsey adopted a zero % basic rate of income tax for companies on 1 January 2008, with higher rates for regulated financial services businesses (10%) and income from property, oil and gas distribution and regulated utilities, etc. (20%). Collective investment schemes ('funds') are exempt from tax and Guernsey does not tax capital gains.

Since 2008, the scope of the 10% and 20% tax rates have been expanded, and so, for example, the profits of large retailers and cultivators of cannabis are now taxed at 20%.

But despite these changes, and numerous increases in other taxes and social security contributions, the public finances of the island have been under continuous pressure since 2008. It is predicted that this pressure will become unsustainable in the medium term, owing to demographic changes.

Quite simply, the zero rate of income tax exempts from tax the profits of most companies operating in Guernsey’s domestic economy. If the company is resident in Guernsey, and its activities are not subject to one of the higher rates of tax, its profits will in general only be charged to tax when those profits are distributed to Guernsey-resident individual shareholders. If the shareholders are not resident in Guernsey, the profits will escape tax entirely because there is no withholding tax on dividends paid to non-residents.

Moreover, since 2012, private investment companies have been used by Guernsey-resident individuals to shelter their investment income from Guernsey tax. By collecting their investment income in a company, they are able to indefinitely defer (and potentially to avoid) tax on income which would be taxable in the hands of other individuals.

However, in many cases, the profits of a Guernsey company will be taxed in another jurisdiction, under controlled foreign company rules. The effect of the Guernsey zero rate is then not to reduce the tax paid by the group of which the company is a member, but to divert that tax to the jurisdiction in which the parent company is resident. For example, about two-thirds of the captive insurance companies in Guernsey are owned by UK parent companies, and they are therefore potentially subject to UK-controlled foreign company rules.

Lyndon Trott corona covid briefing

Pictured: Deputy Lyndon Trott, who led the introduction of zero-10 during the 2004-8 States' term against an alternative model led by Deputy Charles Parkinson.

The Case for Reform

As noted above, Guernsey is now one of a tiny minority of jurisdictions that taxes companies on their worldwide income. It is also one of a diminishing number of territories that operate a zero % tax rate. Even the United Arab Emirates (including Dubai) have recently announced that, from 1 June 2023, they will be levying a corporate income tax at 9%.

Being in such a tiny minority is not of itself an argument for adopting a territorial tax regime, or getting rid of the zero % rate, but it does beg the question: why do we not change to a system used by many of our most successful competitors? Or, to put it the other way round, if zero-10 is such a good idea, why do so few of our competitors use it?

There is no reason in principle why Guernsey should not adopt a territorial tax regime, although this would need to respect the EU guidance, particularly if territorial rules are to apply to passive income. However, at the jurisdictional level, Guernsey has already satisfied the economic substance requirements of the EU, and we have in place a full range of anti-abuse measures. We do not exempt income from taxation by administrative discretion and we have a comprehensive network of exchange of information provisions.

Introducing a territorial corporate income tax, perhaps at a standard rate of 10% or 12.5% with a higher rate of 15% for groups with a turnover exceeding 750m Euros, would bring us into line with international norms, and would bring much-needed revenue into our public exchequer.

However, we must consider how this would affect our finance industry.

I shall analyse this in terms of each of the main sectors in the industry – banking, fund management, captive insurance and fiduciary.

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Pictured: Deputy Charles Parkinson believes that Guernsey's finance industry may have been harmed by the island's zero-10 company tax regime.

Banking

For companies in the regulated financial services sector, including banks, a standard rate of 10% would not increase the tax they pay in Guernsey except to the extent required by the OECD’s global minimum corporate tax rate. Some would continue to pay tax at 10%, but larger groups would have to pay the new global minimum tax rate of 15%.

Fund Management

In line with general practice around the world, the income of funds would remain exempt from Guernsey taxation. The fund managers themselves would continue to pay tax at 10% (or 15%, as the case may be).

Captive Insurance

A point of particular interest would be the source rules for the income of a captive insurance company. These companies have been under pressure to demonstrate their economic substance in Guernsey, under the Base Erosion and Profit Shifting rules of the EU, and the fact that they do not pay tax in Guernsey counts against them in this context. 

Given that in many cases their Guernsey profits are taxed, but taxed in the UK or elsewhere, the case for continuing to exempt their profits is questionable. If they paid tax in Guernsey, in many cases the tax paid here would simply be credited against the group’s tax liabilities elsewhere. So, paying tax in Guernsey would not be a real cost to the group.

However, under the new territorial tax system in Curaçao, the income of a captive insurance company is deemed to be earned where the insured risks are located, and therefore outside the scope of tax in Curaçao. There are good reasons to believe that this treatment is acceptable to the EU. Curaçao is part of the Kingdom of the Netherlands and in EU terms is one of the thirteen Overseas Countries and Territories regarded as having associate status.

Fiduciary

The issue in the fiduciary sector is the tax treatment of private companies, typically owned by trusts. The trusts themselves would not be concerned with any of this because nothing in the above sections relates to the taxation of trusts. But trusts often hold investments and other assets, e.g. yachts, through private companies.

The main objective of investment is to produce capital gains, which are not taxable in Guernsey. This would not change. However, if Guernsey wished to exclude foreign source passive income from the tax base (as I would expect), care would need to be taken to guard against double non-taxation of that income (as seen in the Hong Kong case, mentioned above).

Dividends are usually paid out of taxed income, so they are generally not the problem (from an EU/OECD perspective). But interest and royalties may be paid out of untaxed income, and safeguards would need to be put in place in these respects. Of course, interest income has been almost negligible for many years now.

Given that Guernsey has already satisfied the EU economic substance test, and that we have a full range of exchange of information agreements with other jurisdictions, this problem should be soluble.

Other Matters for Consideration

The 20% tax rate could be retained for Guernsey property income, cannabis etc., as at present.

Other areas that would require careful consideration include the source rules for royalty income and income from franchise operations. These are technical details which would require thorough investigation.

The amount of tax collected by the new regime would depend on the territorial source rules. It would be normal to define foreign source dividends as non-Guernsey source income, and therefore outside the charge to Guernsey tax. Since dividends are normally paid out of taxed income, this would not be controversial. It would similarly be possible to define foreign source interest and royalty income as non-Guernsey source income, subject to appropriate anti-abuse conditions.

Deputy_Mark_Helyar_GST.jpg

Pictured: Deputy Mark Helyar, the Policy & Resources Committee's Treasury Lead, has been leading efforts to persuade States' members and the public of the need for GST, but Deputy Charles Parkinson says the public will not accept a higher tax burden before companies in Guernsey are paying what he calls "their fair share of the costs of our society".

Conclusions

Whether or not these reforms would completely close the anticipated fiscal deficits, it is not possible to say without undertaking the work described above. However, corporate tax reform is a necessary pre-condition for any other tax changes. The Guernsey public can legitimately demand that all participants in the Guernsey economy should pay their fair share of the costs of our society, before the public are asked to pay any more.

The position can be summarised as follows

A territorial corporate tax system would increase the revenues available to the States of Guernsey, primarily by taxing activity within Guernsey’s domestic economy which is not currently taxed.

The amount of additional revenue that would be collected would depend on the detail of the source rules adopted, i.e. the rules defining what income is treated as earned in Guernsey. A crucial variable would be the source rules for insurance income.

The adoption of a territorial corporate income tax regime, with a low but positive rate of tax, would ‘normalise’ Guernsey’s tax system. It would remove the zero rate, which is a red rag to a bull for other tax jurisdictions. It would help rid Guernsey of the stigma of being a ‘tax haven’ and would allow us to rebrand the island.

As such, it would assist our efforts to develop a range of comprehensive double tax treaties and market access agreements.

By taking some of the fiscal pressure off the resident population, it would help to make Guernsey more attractive to locals who wish to remain here and develop their careers here.

The effort to make Guernsey more attractive as a place to live and work (for Guernsey people and immigrants alike) would be assisted by active policies to diversify the economy and to provide affordable housing.

Deputy Charles Parkinson, MA, FCA, Barrister

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